Small banks are major suppliers of credit to small businesses, but that means they could also be a circuit for the transmission of problems in commercial real estate.

Banks with commercial real estate loans in excess of three times Tier 1 capital account for about 40% of small-business loans, Dennis Lockhart, the president of the Federal Reserve Bank of Atlanta, said in a speech in November.

The economy's climb out of recession, he said, could be slowed by a "negative feedback loop" under which small banks — hammered by their disproportionate exposure to commercial real estate assets — pull back lending to small businesses, hindering their ability to add employees at the rate they did in previous recoveries. The drag on employment, in turn, could prolong trouble in commercial real estate by making it harder to fill buildings with tenants.


Outages stemming from the nexus between commercial real estate and small-business lending have already played out in bank failures.

Temecula Valley Bank is a pointed example. It collapsed in July largely because of residential construction loans in California's Inland Empire.

Small-business loans made up 21.4% of Temecula's $1.4 billion of assets at June 30. The company was the eighth-largest originator of loans backed by the government under the Small Business Administration's largest program during the fiscal year that ended in September 2008. But the agency barred Temecula from selling the guaranteed portion of its SBA loans because of a consent order issued by bank regulators in February, and the company decided to stop originating them entirely as it worked to shed assets and refocus on "traditional" banking.

The mix of Temecula's portfolio was typical of small banks — small-business loans made up 14.7% of assets at institutions with assets of less then $2 billion at June 30, compared with 5.2% for the industry as a whole.

Among the third quarter's 50 bank failures, 22 institutions — including Temecula Valley — had ratios of small-business loans to total assets of 15% or more. For most of these banks, commercial real estate loans made up a third to three-quarters of total assets.

Lockhart said he does not expect fallout from commercial real estate to be nearly as severe as what emanated from the far larger housing sector, but he cautioned that "many underestimated the scale and contagion potential" of the latter.

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